Hong Kong Property Prices to Fall 40%?

U.S. rate hikes and weak Chinese growth could accelerate a slide in apartment prices. 3 stocks at risk.

Hong Kong easily takes the wooden spoon when it comes to housing affordability. An average salary earner would need to work 17 years to make enough money to buy an average apartment in the densely populated city.

A bustling economy buoyed by a rapidly rising China, voracious demand from mainland Chinese buyers wanting to invest new found riches, as well as near zero interest rates for the past seven years fueled the boom. Home prices have climbed almost four fold over the past 12 years. Back in 2003, the Centa-City Leading Index, a weekly benchmark of contract prices for housing transactions, was returning readings in the low 30s. By September of this year, that number had soared to just a tad below 147.

However, China’s economic slowdown, which has spilled over into Hong Kong, combined with anticipation of a U.S. rate hike and moves by Hong Kong’s government to cool the housing market, have taken some heat out of the market. Housing prices have declined for four weeks straight, falling 3.5% from their September peak. The downturn in the housing market has weighed on shares of Hong Kong’s real estate companies, with the property section of the Hang Seng Index down 5% over the past week.

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This could be just the beginning of more property market weakness. Deutsche Bank’s Tony Tsang is among a growing contingent of analysts who are projecting a fall of 30% or more for Hong Kong housing prices. Tsang’s argument rests on the fact that Hong Kong banks are restricted to a debt servicing ratio of 50% or less on mortgages. However, current residential property prices imply a debt servicing ratio, which measures monthly mortgage payments as a share of monthly income, of about 72% for a typical 20-year mortgage on an archetypal 40 to 70 square meter apartment, estimates Tsang. The analyst argues that “for the affordability ratio to return to a sustainable level of 50%, residential prices would need to fall 32%.”

And that’s even before factoring in looming U.S. rate hikes, with stronger than expected jobs data boosting the probability of an increase in interest rates in December. Because the Hong Kong dollar is pegged to the greenback, movements in U.S. rates are mirrored by Hong Kong rates. A 25 basis point hike would increase monthly mortgage payments by roughly 2.3%, which would worsen the affordability ratio to 74% and call for a 33% drop in housing prices, notes Tsang. What’s more, if Hong Kong mortgage rates return to levels averaged between 2003 and 2007, which would be the case if the Fed delivered 165 basis points of hikes, then a 40% correction in residential property prices from current levels would be needed to restore the affordability ratio to 50%, estimates Tsang.

Barclays analyst Paul Louie takes a novel approach to determine where Hong Kong prices could be headed. He applies technical analysis, typically used by stock chartists, to housing prices to predict what the future may hold. “Just as technical analysis can be useful in understanding stock momentum, it may also shed light on home price momentum,” writes Louie. The analyst notes that market sentiment is likely to be turning increasingly bearish as falls have already crossed the psychologically important threshold of three weeks of back-to-back declines. If prices continue to head south at the current pace, then an ominous “death cross,” a bearish technical indicator, could form in eight weeks’ time. That could see housing prices retrace to a key support level that’s 16% below current levels.

Falling prices aren’t the only problem that Hong Kong’s property developers and real estate investment trusts could face. The industry carries large piles of debt on their balance sheets to finance operations, so rising U.S. rates would increase funding costs and squeeze margins. Deutsche Bank’s Tsang expects REITs to suffer a greater hit than developers, with the former forecast to suffer earnings declines of between 2% and 4% on a 25 basis point rate hike. Property developers would suffer an earnings hit of between 1% and 3%. In terms of net asset values, REITs could see values fall between 4% and 14%, which is much higher than the 2% to 3% expected for developers. While cap rates for REITs, which is a measure of the rate of return on an investment property, usually rise with interest rates, the effect is likely to be outweighed by higher funding costs.

Among Hong Kong’s real estate companies, Great Eagle Holdings ( 41.HK ), Hysan Development ( 14.HK ) and Link REIT ( 823.HK ) are three that could be in for the toughest time.

Great Eagle, which largely earns its revenues from property investments via majority stakes in Champion Real Estate Investment Trust ( 2778.HK ) and Langham Hospitality Investments ( 1270.HK ), could suffer a 14% decline in net asset value and a 4.3% fall in 2016 earnings on a 25 basis point rate hike, estimates Tsang. The company’s hotel operations in Hong Kong have also been hit by falling tourist numbers from mainland China, which drove a 13% decrease in 2015 first half profits compared to a year ago. “Management’s tone on operating conditions in the second half is pessimistic,” notes Credit Suisse analyst Kelvin Tam, who has an underperform rating on Great Eagle. Tam’s target price of HKD20.95 a share is 14% below the stock’s current levels of around HKD24.50.

For Hysan, one of Hong Kong’s oldest property developers and investors, the dent to net asset value could amount to 5.6%, while the hit to 2016 earnings is expected to be a much lower 0.5%. Link REIT, which is the largest real estate investment trust in Asia, could see a 1.9% fall in 2016 earnings and a 5.4% fall in net asset value. The REIT is scheduled to announce results for the six months to September on Wednesday. Credit Suisse’s Tam, who has an underperform rating on the stock and sees 8% downside from its current levels around HKD44.90 a share, expects Link REIT to deliver a distribution per unit of HKD0.96, which is up 7% compared to the same period a year ago.